1. 16.1 Van Horne and Wachowicz, Fundamentals of Financial Management, 13th edition. © Pearson Education Limited 2009. Created by Gregory Kuhlemeyer. Chapter 16 Operating and Financial Leverage

2. 16.2 Van Horne and Wachowicz, Fundamentals of Financial Management, 13th edition. © Pearson Education Limited 2009. Created by Gregory Kuhlemeyer. 1.Define operating and financial leverage and identify causes of both. 2.Calculate a firm’s operating break-even (quantity) point and break-even (sales) point. 3.Define, calculate, and interpret a firm's degree of operating, financial, and total leverage. 4.Understand EBIT-EPS break-even, or indifference, analysis, and construct and interpret an EBIT-EPS chart. 5.Define, discuss, and quantify “total firm risk” and its two components, “business risk” and “financial risk.” 6.Understand what is involved in determining the appropriate amount of financial leverage for a firm. After Studying Chapter 16, you should be able to:

3. 16.3 Van Horne and Wachowicz, Fundamentals of Financial Management, 13th edition. © Pearson Education Limited 2009. Created by Gregory Kuhlemeyer. Operating Leverage Financial Leverage Total Leverage Cash-Flow Ability to Service Debt Other Methods of Analysis Combination of Methods Operating and Financial Leverage

4. 16.4 Van Horne and Wachowicz, Fundamentals of Financial Management, 13th edition. © Pearson Education Limited 2009. Created by Gregory Kuhlemeyer. Leverage Capital structure refers to the mix of long term debt and equity maintained by the firm Leverage results from the use of fixed cost assets to magnify returns to the firm’s owners  increased leverage raises risk/return  decreased leverage lowers risk/return Management can control leverage in the capital structure, and in turn affect firm value

5. 16.5 Van Horne and Wachowicz, Fundamentals of Financial Management, 13th edition. © Pearson Education Limited 2009. Created by Gregory Kuhlemeyer. Leverage Three types of leverage : Operating leverage – relates sales to EBIT Financial leverage – relates EBIT to EPS Total leverage – relates sales to EPS Mathematically, these three measures of leverage are related as follows:  Operating leverage × financial leverage = total leverage  sales/EBIT x EBIT/EPS = sales/EPS

6. 16.6 Van Horne and Wachowicz, Fundamentals of Financial Management, 13th edition. © Pearson Education Limited 2009. Created by Gregory Kuhlemeyer. Types of leverage and income statement:

7. 16.7 Van Horne and Wachowicz, Fundamentals of Financial Management, 13th edition. © Pearson Education Limited 2009. Created by Gregory Kuhlemeyer. One potential “effect” caused by the presence of operating leverage is that a change in the volume of sales results in a “more than proportional” change in operating profit (or loss). Operating Leverage – The use of fixed operating costs by the firm. Operating Leverage

8. 16.8 Van Horne and Wachowicz, Fundamentals of Financial Management, 13th edition. © Pearson Education Limited 2009. Created by Gregory Kuhlemeyer. Firm F Firm V Firm 2F Sales$10$11 $19.5 Operating Costs Fixed 7 2 14 Variable 2 7 3 $1$ 2 $ 2.5 Operating Profit$ 1$ 2 $ 2.5 FC/total costs 0.78 0.22 0.82 FC/sales 0.70 0.18 0.72 (in thousands) Impact of Operating Leverage on Profits

9. 16.9 Van Horne and Wachowicz, Fundamentals of Financial Management, 13th edition. © Pearson Education Limited 2009. Created by Gregory Kuhlemeyer. 50% increase in salesNow, subject each firm to a 50% increase in sales for next year. “sensitive”Which firm do you think will be more “sensitive” to the change in sales (i.e., show the largest percentage change in operating profit, EBIT)? Firm FFirm VFirm 2F [ ] Firm F; [ ] Firm V; [ ] Firm 2F. Impact of Operating Leverage on Profits

10. 16.10 Van Horne and Wachowicz, Fundamentals of Financial Management, 13th edition. © Pearson Education Limited 2009. Created by Gregory Kuhlemeyer. Firm F Firm V Firm 2F Sales$15 $16.5 $29.25 Operating Costs Fixed 7 2 14 Variable 310.5 4.5 $5 $ 4 $10.75 Operating Profit$ 5 $ 4 $10.75 Percentage Change in EBIT400% 100% 330% Percentage Change in EBIT*400% 100% 330% (in thousands) * (EBIT t - EBIT t-1 ) / EBIT t-1 Impact of Operating Leverage on Profits

11. 16.11 Van Horne and Wachowicz, Fundamentals of Financial Management, 13th edition. © Pearson Education Limited 2009. Created by Gregory Kuhlemeyer. Firm F is the most “sensitive” firmFirm F is the most “sensitive” firm – for it, a 50% increase in sales leads to a 400% increase in EBIT 400% increase in EBIT. Our example reveals that it is a mistake to assume that the firm with the largest absolute or relative amount of fixed costs automatically shows the most dramatic effects of operating leverage. Later, we will come up with an easy way to spot the firm that is most sensitive to the presence of operating leverage. Impact of Operating Leverage on Profits

12. 16.12 Van Horne and Wachowicz, Fundamentals of Financial Management, 13th edition. © Pearson Education Limited 2009. Created by Gregory Kuhlemeyer. When studying operating leverage, “profits” refers to operating profits before taxes (i.e., EBIT) and excludes debt interest and dividend payments. Break-Even Analysis profits Break-Even Analysis – A technique for studying the relationship among fixed costs, variable costs, sales volume, and profits. Also called cost/volume/profit analysis (C/V/P) analysis. Break-Even Analysis

13. 16.13 Van Horne and Wachowicz, Fundamentals of Financial Management, 13th edition. © Pearson Education Limited 2009. Created by Gregory Kuhlemeyer. QUANTITY PRODUCED AND SOLD 4,000 0 1,000 2,000 3,000 4,000 5,000 6,000 7,000 Total Revenues Profits Fixed Costs Variable Costs Losses REVENUES AND COSTS ($ thousands) 175 250 100 50 Total Costs Break-Even Chart

14. 16.14 Van Horne and Wachowicz, Fundamentals of Financial Management, 13th edition. © Pearson Education Limited 2009. Created by Gregory Kuhlemeyer. How to find the quantity break-even point: PQVQFC EBIT = P(Q) – V(Q) – FC QPVFC EBIT = Q(P – V) – FC P = Price per unitV = Variable costs per unit P = Price per unit V = Variable costs per unit FC = Fixed costs Q = Quantity (units) produced and sold FC = Fixed costs Q = Quantity (units) produced and sold Break-Even Point – The sales volume required so that total revenues and total costs are equal; may be in units or in sales dollars. Break-Even (Quantity) Point

15. 16.15 Van Horne and Wachowicz, Fundamentals of Financial Management, 13th edition. © Pearson Education Limited 2009. Created by Gregory Kuhlemeyer. Break-Even (Quantity) Point EBIT = Q(P – VC) – FC, so Q = FC/(P – VC) = Breakeven point

16. 16.16 Van Horne and Wachowicz, Fundamentals of Financial Management, 13th edition. © Pearson Education Limited 2009. Created by Gregory Kuhlemeyer. Breakeven occurs when EBIT = 0 Q PVFC Q (P – V) – FC= EBIT Q BE PVFC Q BE (P – V) – FC = 0 Q BE PVFC Q BE (P – V) = FC Q BE FC PV Q BE = FC / (P – V) a.k.a. Unit Contribution Margin Break-Even (Quantity) Point

17. 16.17 Van Horne and Wachowicz, Fundamentals of Financial Management, 13th edition. © Pearson Education Limited 2009. Created by Gregory Kuhlemeyer. How to find the sales break-even point: S BE FCVC BE S BE = FC + (VC BE ) S BE FC Q BE V S BE = FC + (Q BE )(V) or S BE * FCVC S BE * = FC / [1 – (VC / S) ] * Refer to text for derivation of the formula Break-Even (Sales) Point

18. 16.18 Van Horne and Wachowicz, Fundamentals of Financial Management, 13th edition. © Pearson Education Limited 2009. Created by Gregory Kuhlemeyer. quantity and sales break-even points Basket Wonders (BW) wants to determine both the quantity and sales break-even points when: Fixed costs $100,000Fixed costs are $100,000 $43.75eachBaskets are sold for $43.75 each $18.75 per basketVariable costs are $18.75 per basket Break-Even Point Example

19. 16.19 Van Horne and Wachowicz, Fundamentals of Financial Management, 13th edition. © Pearson Education Limited 2009. Created by Gregory Kuhlemeyer. Breakeven occurs when: Q BE FC PV Q BE = FC / (P – V) Q BE $100,000 $43.75$18.75 Q BE = $100,000 / ($43.75 – $18.75) Q BE 4,000 Units Q BE = 4,000 Units S BE Q BE VFC S BE = (Q BE )(V) + FC S BE 4,000$18.75$100,000 S BE = (4,000 )($18.75) + $100,000 S BE $175,000 S BE = $175,000 Break-Even Point (s)

20. 16.20 Van Horne and Wachowicz, Fundamentals of Financial Management, 13th edition. © Pearson Education Limited 2009. Created by Gregory Kuhlemeyer. Break-Even Point Lv Xi has fixed operating costs of $2,500, the sale price per unit is $10, and variable operating cost per unit is $5. What is the BE point? Q = 2,500/(10 – 5) = 500 units At sales of 500 units, the firm’s EBIT equals $0. The firm will have positive EBIT for sales greater than 500 units and negative EBIT, or a loss, for sales less than 500 units. You can confirm this by substituting values above and below 500 units, along with the other values given into the equation.

21. 16.21 Van Horne and Wachowicz, Fundamentals of Financial Management, 13th edition. © Pearson Education Limited 2009. Created by Gregory Kuhlemeyer. Break-Even Point LvXi wishes to evaluate the impact of several options: (1) increasing fixed operating costs to $3000, (2) increasing the sales price per unit to $12.50, (3) increasing the variable operating cost per unit to $7.50, and (4) simultaneously implementing all three of these changes. Substituting the appropriate data into Equation 16.3 yields the following:

22. 16.22 Van Horne and Wachowicz, Fundamentals of Financial Management, 13th edition. © Pearson Education Limited 2009. Created by Gregory Kuhlemeyer. Break-Even Point 1. OPB = 3000/(10 – 5) = 600 units 2. OPB = 2500/(12.50 – 5) = 333.33 units 3. OPB = 2500/(10 – 7.50) = 1000 units 4. OPB = 3000/(12.50 – 7.50) = 600 units Actions 1&3 (cost increases) raise OPB Action 2 (revenue inc.) lowers OPB Action 4 (combined) increases OPB

23. 16.23 Van Horne and Wachowicz, Fundamentals of Financial Management, 13th edition. © Pearson Education Limited 2009. Created by Gregory Kuhlemeyer. Break-Even Point Break-even analysis: – sensitivity increase in variable effect on OPB FC increase P decrease VC increase OPB = Operating break-even point

24. 16.24 Van Horne and Wachowicz, Fundamentals of Financial Management, 13th edition. © Pearson Education Limited 2009. Created by Gregory Kuhlemeyer. QUANTITY PRODUCED AND SOLD 4,000 0 1,000 2,000 3,000 4,000 5,000 6,000 7,000 Total Revenues Profits Fixed Costs Variable Costs Losses REVENUES AND COSTS ($ thousands) 175 250 100 50 Total Costs Break-Even Chart

25. 16.25 Van Horne and Wachowicz, Fundamentals of Financial Management, 13th edition. © Pearson Education Limited 2009. Created by Gregory Kuhlemeyer. DOL DOL at Q units of output (or sales) Degree of Operating Leverage Degree of Operating Leverage – The percentage change in a firm’s operating profit (EBIT) resulting from a 1 percent change in output (sales). = Percentage change in operating profit (EBIT) Percentage change in output (or sales) Degree of Operating Leverage (DOL)

26. 16.26 Van Horne and Wachowicz, Fundamentals of Financial Management, 13th edition. © Pearson Education Limited 2009. Created by Gregory Kuhlemeyer. Degree of Operating Leverage (DOL)

27. 16.27 Van Horne and Wachowicz, Fundamentals of Financial Management, 13th edition. © Pearson Education Limited 2009. Created by Gregory Kuhlemeyer. Degree of Operating Leverage (DOL) Operating leverage: the potential use of fixed operating costs to magnify the effects of changes in sales on the firm’s EBIT  an increase (decrease) in sales results in a more-than-proportionate increase (decrease) in EBIT the ‘degree of operating leverage’ (DOL) equals: DOL = (% change EBIT) / (% change sales) An alternative formula (at base sales level, Q) is: DOL = Q(P – VC)/[Q(P – VC) – FC]

28. 16.28 Van Horne and Wachowicz, Fundamentals of Financial Management, 13th edition. © Pearson Education Limited 2009. Created by Gregory Kuhlemeyer. DOL Q units Calculating the DOL for a single product or a single-product firm. = QPV Q (P – V) QPVFC Q (P – V) – FC = Q QQ BE Q – Q BE Computing the DOL

29. 16.29 Van Horne and Wachowicz, Fundamentals of Financial Management, 13th edition. © Pearson Education Limited 2009. Created by Gregory Kuhlemeyer. DOL S dollars of sales Calculating the DOL for a multiproduct firm. = SVC S – VC SVCFC S – VC – FC = FC EBIT + FC EBIT Computing the DOL

30. 16.30 Van Horne and Wachowicz, Fundamentals of Financial Management, 13th edition. © Pearson Education Limited 2009. Created by Gregory Kuhlemeyer. degree of operating leverage sales levels of 6,000 and 8,000 units Lisa Miller wants to determine the degree of operating leverage at sales levels of 6,000 and 8,000 units. As we did earlier, we will assume that: Fixed costs $100,000Fixed costs are $100,000 $43.75eachBaskets are sold for $43.75 each $18.75 per basketVariable costs are $18.75 per basket Break-Even Point Example

31. 16.31 Van Horne and Wachowicz, Fundamentals of Financial Management, 13th edition. © Pearson Education Limited 2009. Created by Gregory Kuhlemeyer. DOL 6,000 units Computation based on the previously calculated break-even point of 4,000 units = 6,000 6,000 4,000 6,000 – 4,000 = = 3 DOL 8,000 units 8,000 8,000 4,000 8,000 – 4,000 = 2 Computing BW’s DOL

32. 16.32 Van Horne and Wachowicz, Fundamentals of Financial Management, 13th edition. © Pearson Education Limited 2009. Created by Gregory Kuhlemeyer. A 1% increase in sales above the 8,000 unit level increases EBIT by 2% because of the existing operating leverage of the firm. = DOL 8,000 units 8,000 8,000 4,000 8,000 – 4,000 = 2 Interpretation of the DOL

33. 16.33 Van Horne and Wachowicz, Fundamentals of Financial Management, 13th edition. © Pearson Education Limited 2009. Created by Gregory Kuhlemeyer. 2,000 4,000 6,000 8,000 1 2 3 4 5 QUANTITY PRODUCED AND SOLD 0 –1 –2 –3 –4 –5 DEGREE OF OPERATING LEVERAGE (DOL) Q BE Interpretation of the DOL

34. 16.34 Van Horne and Wachowicz, Fundamentals of Financial Management, 13th edition. © Pearson Education Limited 2009. Created by Gregory Kuhlemeyer. Interpretation of the DOL Lv Xi swaps part of its variable operating costs (eliminating sales commissions) for fixed operating costs (increasing sales salaries). Result - a reduction in the variable operating cost per unit from $5 to $4.50 and an increase in the fixed operating costs from $2,500 to $3,000. EBIT of $2,500 at the 1,000-unit sales level is unchanged. What is Lv Xi’s DOL? DOL = Q(P – VC)/[Q(P – VC) – FC] = 1,000(10 – 4.50)/[1,000(10 – 4.50) – 3,000] =2.2 Thus, the higher the firm’s fixed operating costs relative to variable operating costs, the greater the degree of operating leverage.

35. 16.35 Van Horne and Wachowicz, Fundamentals of Financial Management, 13th edition. © Pearson Education Limited 2009. Created by Gregory Kuhlemeyer. DOL is a quantitative measure of the “sensitivity” of a firm’s operating profit to a change in the firm’s sales. The closer that a firm operates to its break-even point, the higher is the absolute value of its DOL. When comparing firms, the firm with the highest DOL is the firm that will be most “sensitive” to a change in sales. Key Conclusions to be Drawn from the previous slide and our Discussion of DOL Interpretation of the DOL

36. 16.36 Van Horne and Wachowicz, Fundamentals of Financial Management, 13th edition. © Pearson Education Limited 2009. Created by Gregory Kuhlemeyer. one component only in the presence of sales and production cost variabilityDOL is only one component of business risk and becomes “active” only in the presence of sales and production cost variability. magnifiesDOL magnifies the variability of operating profits and, hence, business risk. Business Risk – The inherent uncertainty in the physical operations of the firm. Its impact is shown in the variability of the firm’s operating income (EBIT). DOL and Business Risk

37. 16.37 Van Horne and Wachowicz, Fundamentals of Financial Management, 13th edition. © Pearson Education Limited 2009. Created by Gregory Kuhlemeyer. Use the data in Slide 16–8 and the following formula for Firm F : DOL = [(EBIT + FC)/EBIT] = DOL $10,000 sales 1,000 + 7,000 1,000 = 8.0 Application of DOL for Our Three Firm Example

38. 16.38 Van Horne and Wachowicz, Fundamentals of Financial Management, 13th edition. © Pearson Education Limited 2009. Created by Gregory Kuhlemeyer. Use the data in Slide 16–8 and the following formula for Firm V : DOL = [(EBIT + FC)/EBIT] = DOL $11,000 sales 2,000 + 2,000 2,000 = 2.0 Application of DOL for Our Three Firm Example

39. 16.39 Van Horne and Wachowicz, Fundamentals of Financial Management, 13th edition. © Pearson Education Limited 2009. Created by Gregory Kuhlemeyer. Use the data in Slide 16–8 and the following formula for Firm 2F : DOL = [(EBIT + FC)/EBIT] = DOL $19,500 sales 2,500 + 14,000 2,500 = 6.6 Application of DOL for Our Three-Firm Example

40. 16.40 Van Horne and Wachowicz, Fundamentals of Financial Management, 13th edition. © Pearson Education Limited 2009. Created by Gregory Kuhlemeyer. The ranked results indicate that the firm most sensitive to the presence of operating leverage is Firm F The ranked results indicate that the firm most sensitive to the presence of operating leverage is Firm F. Firm FDOL = 8.0 Firm VDOL = 6.6 Firm 2FDOL = 2.0 Firm F will expect a 400% increase in profit from a 50% increase in sales (see Slide 16–10 results). Application of DOL for Our Three-Firm Example

41. 16.41 Van Horne and Wachowicz, Fundamentals of Financial Management, 13th edition. © Pearson Education Limited 2009. Created by Gregory Kuhlemeyer. Financial leverage is acquired by choice. Used as a means of increasing the return to common shareholders. Financial Leverage – The use of fixed financing costs by the firm. The British expression is gearing. Financial Leverage

42. 16.42 Van Horne and Wachowicz, Fundamentals of Financial Management, 13th edition. © Pearson Education Limited 2009. Created by Gregory Kuhlemeyer. EPS EBIT Calculate EPS for a given level of EBIT at a given financing structure. EBIT-EPS Break-Even Analysis – Analysis of the effect of financing alternatives on earnings per share. The break-even point is the EBIT level where EPS is the same for two (or more) alternatives. EBIT (EBIT – I) (1 – t) – Pref. Div. # of Common Shares EPS= EBIT-EPS Break-Even, or Indifference, Analysis

43. 16.43 Van Horne and Wachowicz, Fundamentals of Financial Management, 13th edition. © Pearson Education Limited 2009. Created by Gregory Kuhlemeyer. Current common equity shares = 50,000Current common equity shares = 50,000 $1 million in new financing of either:$1 million in new financing of either: All C.S. sold at $20/share (50,000 shares) All debt with a coupon rate of 10% All Pref.Shares with a dividend rate of 9% Expected EBIT = $500,000Expected EBIT = $500,000 Income tax rate is 30%Income tax rate is 30% Basket Wonders has $2 million in LT financing (100% common stock equity). EBIT-EPS Chart

44. 16.44 Van Horne and Wachowicz, Fundamentals of Financial Management, 13th edition. © Pearson Education Limited 2009. Created by Gregory Kuhlemeyer. EBIT $500,000 $150,000 EBIT $500,000 $150,000* Interest 0 0 EBT $500,000 $150,000 Taxes (30% x EBT) 150,000 45,000 EAT $350,000 $105,000 Preferred Dividends 0 0 EACS $350,000 $105,000 # of Shares 100,000 100,000 EPS $3.50 $1.05 Common Stock Equity Alternative * A second analysis using $150,000 EBIT rather than the expected EBIT. EBIT-EPS Calculation with New Equity Financing

45. 16.45 Van Horne and Wachowicz, Fundamentals of Financial Management, 13th edition. © Pearson Education Limited 2009. Created by Gregory Kuhlemeyer. 0 100 200 300 400 500 600 700 EBIT ($ thousands) Earnings per Share ($) 0 1 2 3 4 5 6 Common EBIT-EPS Chart

46. 16.46 Van Horne and Wachowicz, Fundamentals of Financial Management, 13th edition. © Pearson Education Limited 2009. Created by Gregory Kuhlemeyer. EBIT $500,000 $150,000 EBIT $500,000 $150,000* Interest 100,000 100,000 EBT $400,000 $ 50,000 Taxes (30% x EBT) 120,000 15,000 EAT $280,000 $ 35,000 Preferred Dividends 0 0 EACS $280,000 $ 35,000 # of Shares 50,000 50,000 EPS $5.60 $0.70 Long-term Debt Alternative * A second analysis using $150,000 EBIT rather than the expected EBIT. EBIT-EPS Calculation with New Debt Financing

47. 16.47 Van Horne and Wachowicz, Fundamentals of Financial Management, 13th edition. © Pearson Education Limited 2009. Created by Gregory Kuhlemeyer. 0 100 200 300 400 500 600 700 EBIT ($ thousands) Earnings per Share ($) 0 1 2 3 4 5 6 Common Debt Indifference point debt between debt and common stock financing EBIT-EPS Chart

48. 16.48 Van Horne and Wachowicz, Fundamentals of Financial Management, 13th edition. © Pearson Education Limited 2009. Created by Gregory Kuhlemeyer. EBIT $500,000 $150,000 EBIT $500,000 $150,000* Interest 0 0 EBT $500,000 $150,000 Taxes (30% x EBT) 150,000 45,000 EAT $350,000 $105,000 Preferred Dividends 90,000 90,000 EACS $260,000 $ 15,000 # of Shares 50,000 50,000 EPS $5.20 $0.30 Preferred Stock Alternative * A second analysis using $150,000 EBIT rather than the expected EBIT. EBIT-EPS Calculation with New Preferred Financing

49. 16.49 Van Horne and Wachowicz, Fundamentals of Financial Management, 13th edition. © Pearson Education Limited 2009. Created by Gregory Kuhlemeyer. 0 100 200 300 400 500 600 700 EBIT ($ thousands) Earnings per Share ($) 0 1 2 3 4 5 6 Common Debt Indifference point preferred between preferred stock common stock and common stock stock financing Preferred EBIT-EPS Chart

50. 16.50 Van Horne and Wachowicz, Fundamentals of Financial Management, 13th edition. © Pearson Education Limited 2009. Created by Gregory Kuhlemeyer. 0 100 200 300 400 500 600 700 EBIT ($ thousands) Earnings per Share ($) 0 1 2 3 4 5 6 Common Debt Lower risk Lower risk. Only a small probability that EPS will be less if the debt alternative is chosen. Probability of Occurrence (for the probability distribution) What About Risk?

51. 16.51 Van Horne and Wachowicz, Fundamentals of Financial Management, 13th edition. © Pearson Education Limited 2009. Created by Gregory Kuhlemeyer. 0 100 200 300 400 500 600 700 EBIT ($ thousands) Earnings per Share ($) 0 1 2 3 4 5 6 Common Debt Higher risk Higher risk. A much larger probability that EPS will be less if the debt alternative is chosen. Probability of Occurrence (for the probability distribution) What About Risk?

52. 16.52 Van Horne and Wachowicz, Fundamentals of Financial Management, 13th edition. © Pearson Education Limited 2009. Created by Gregory Kuhlemeyer. DFL DFL at EBIT of X dollars Degree of Financial Leverage Degree of Financial Leverage – The percentage change in a firm’s earnings per share (EPS) resulting from a 1 percent change in operating profit. = Percentage change in earnings per share (EPS) Percentage change in operating profit (EBIT) Degree of Financial Leverage (DFL)

53. 16.53 Van Horne and Wachowicz, Fundamentals of Financial Management, 13th edition. © Pearson Education Limited 2009. Created by Gregory Kuhlemeyer. DFL DFL EBIT of $X Calculating the DFL = EBIT EBIT IPDt EBIT – I – [ PD / (1 – t) ] EBIT = Earnings before interest and taxes I = Interest PD = Preferred dividends t = Corporate tax rate Computing the DFL

54. 16.54 Van Horne and Wachowicz, Fundamentals of Financial Management, 13th edition. © Pearson Education Limited 2009. Created by Gregory Kuhlemeyer. DFL $500,000 Calculating the DFL for NEW equityalternative Calculating the DFL for NEW equity* alternative = $500,000 $500,000 000 $500,000 – 0 – [0 / (1 – 0)] * The calculation is based on the expected EBIT = 1.00 What is the DFL for Each of the Financing Choices?

55. 16.55 Van Horne and Wachowicz, Fundamentals of Financial Management, 13th edition. © Pearson Education Limited 2009. Created by Gregory Kuhlemeyer. DFL $500,000 Calculating the DFL for NEW debt alternative Calculating the DFL for NEW debt * alternative = $500,000 { $500,000 100,000 { $500,000 – 100,000 00 – [0 / (1 – 0)] } * The calculation is based on the expected EBIT = $500,000 $500,000 / $400,000 1.25 = What is the DFL for Each of the Financing Choices?

56. 16.56 Van Horne and Wachowicz, Fundamentals of Financial Management, 13th edition. © Pearson Education Limited 2009. Created by Gregory Kuhlemeyer. DFL $500,000 Calculating the DFL for NEW preferred alternative Calculating the DFL for NEW preferred * alternative = $500,000 { $500,000 0 { $500,000 – 0 90,0000.30 – [90,000 / (1 – 0.30)] } * The calculation is based on the expected EBIT = $500,000 $500,000 / $371,429 1.35 = What is the DFL for Each of the Financing Choices?

57. 16.57 Van Horne and Wachowicz, Fundamentals of Financial Management, 13th edition. © Pearson Education Limited 2009. Created by Gregory Kuhlemeyer. Preferred stockPreferred stock financing will lead to the greatest variability in earnings per share based on the DFL. This is due to the tax deductibility of interest on debt financing. DFL Equity = 1.00 DFL Debt = 1.25 DFL Preferred = 1.35 greatest relative variability in EPS? Which financing method will have the greatest relative variability in EPS? Variability of EPS

58. 16.58 Van Horne and Wachowicz, Fundamentals of Financial Management, 13th edition. © Pearson Education Limited 2009. Created by Gregory Kuhlemeyer. Debt increases the probability of cash insolvency over an all-equity-financed firm. For example, our example firm must have EBIT of at least $100,000 to cover the interest payment. Debt also increased the variability in EPS as the DFL increased from 1.00 to 1.25. Financial Risk – The added variability in earnings per share (EPS) – plus the risk of possible insolvency – that is induced by the use of financial leverage. Financial Risk

59. 16.59 Van Horne and Wachowicz, Fundamentals of Financial Management, 13th edition. © Pearson Education Limited 2009. Created by Gregory Kuhlemeyer. CV EPS total firm riskCV EPS is a measure of relative total firm risk CV EBIT business riskCV EBIT is a measure of relative business risk CV EPS – CV EBIT financial riskThe difference, CV EPS – CV EBIT, is a measure of relative financial risk Total Firm Risk – The variability in earnings per share (EPS). It is the sum of business plus financial risk. Total firm risk business risk financial risk Total firm risk = business risk + financial risk Total Firm Risk

60. 16.60 Van Horne and Wachowicz, Fundamentals of Financial Management, 13th edition. © Pearson Education Limited 2009. Created by Gregory Kuhlemeyer. Total Leverage Total leverage: the potential use of both operating and financial fixed costs to magnify the effects of changes in sales on the firm’s EPS  an increase (decrease) in sales results in a more-than-proportionate increase (decrease) in EPS the ‘degree of total leverage’ (DTL) equals: DTL = (% change EPS) / (% change sales), or DTL = Q(P – VC)/[Q(P – VC) – FC – I – (Dp/(1 – t))]

61. 16.61 Van Horne and Wachowicz, Fundamentals of Financial Management, 13th edition. © Pearson Education Limited 2009. Created by Gregory Kuhlemeyer. Total Leverage Li Da Ltd expects annual sales of 20,000 units at $5 per unit and incurs variable operating costs of $2 per unit, fixed operating costs of $10,000, interest of $20,000 and preference dividends of $12,000. The firm is in the 40% tax bracket and has issued 5,000 ordinary shares. The next slide presents the levels of EPS associated with the expected sales of 20,000 units and with sales of 30, 000 units.

62. 16.62 Van Horne and Wachowicz, Fundamentals of Financial Management, 13th edition. © Pearson Education Limited 2009. Created by Gregory Kuhlemeyer. Total Leverage

63. 16.63 Van Horne and Wachowicz, Fundamentals of Financial Management, 13th edition. © Pearson Education Limited 2009. Created by Gregory Kuhlemeyer. DTL DTL at Q units (or S dollars) of output (or sales) Degree of Total Leverage Degree of Total Leverage – The percentage change in a firm’s earnings per share (EPS) resulting from a 1 percent change in output (sales). = Percentage change in earnings per share (EPS) Percentage change in output (or sales) Degree of Total Leverage (DTL)

64. 16.64 Van Horne and Wachowicz, Fundamentals of Financial Management, 13th edition. © Pearson Education Limited 2009. Created by Gregory Kuhlemeyer. DTL DTL S dollars of sales DTL Q units (or S dollars) DOL Q units (or S dollars) DFL EBIT of X dollars DTL Q units (or S dollars) = ( DOL Q units (or S dollars) ) x ( DFL EBIT of X dollars ) Note: the relationship is multiplicative, not additive. = EBIT EBIT + FC EBIT IPDt EBIT – I – [ PD / (1 – t) ] DTL DTL Q units QP V Q (P – V) QP VIPDt Q (P – V) – FC – I – [ PD / (1 – t) ] = Computing the DTL

65. 16.65 Van Horne and Wachowicz, Fundamentals of Financial Management, 13th edition. © Pearson Education Limited 2009. Created by Gregory Kuhlemeyer. Degree of Total Leverage EBIT=$500,000. Lisa Miller wants to determine the Degree of Total Leverage at EBIT=$500,000. As we did earlier, we will assume that: Fixed costs $100,000Fixed costs are $100,000 $43.75eachBaskets are sold for $43.75 each $18.75 per basketVariable costs are $18.75 per basket DTL Example

66. 16.66 Van Horne and Wachowicz, Fundamentals of Financial Management, 13th edition. © Pearson Education Limited 2009. Created by Gregory Kuhlemeyer. DTL DTL S dollars of sales = $500,000 $500,000 + $100,000 $500,000 000.3 $500,000 – 0 – [ 0 / (1 – 0.3) ] DTL S dollars DOL S dollars DFL EBIT of $S DTL S dollars = (DOL S dollars ) x (DFL EBIT of $S ) DTL S dollars 1.2 1.0 1.20 DTL S dollars = (1.2 ) x ( 1.0* ) = 1.20 = 1.20 *Note: No financial leverage. Computing the DTL for All-Equity Financing

67. 16.67 Van Horne and Wachowicz, Fundamentals of Financial Management, 13th edition. © Pearson Education Limited 2009. Created by Gregory Kuhlemeyer. DTL DTL S dollars of sales = $500,000 $500,000 + $100,000 $500,000 $100,000 { $500,000 – $100,000 00.3 – [ 0 / (1 – 0.3) ] } DTL S dollars DOL S dollars DFL EBIT of $S DTL S dollars = (DOL S dollars ) x (DFL EBIT of $S ) DTL S dollars 1.2 1.25 1.50 DTL S dollars = (1.2 ) x ( 1.25* ) = 1.50 = 1.50 *Note: Calculated on Slide 16.44. Computing the DTL for Debt Financing

68. 16.68 Van Horne and Wachowicz, Fundamentals of Financial Management, 13th edition. © Pearson Education Limited 2009. Created by Gregory Kuhlemeyer. Compare the expected EPS to the DTL for the common stock equity financing approach to the debt financing approach. FinancingE(EPS)DTL Financing E(EPS)DTL Equity$3.501.20 Equity$3.501.20 Debt$5.601.50 Debt$5.601.50 Greater expected return (higher EPS) comes at the expense of greater potential risk (higher DTL)! Risk versus Return

69. 16.69 Van Horne and Wachowicz, Fundamentals of Financial Management, 13th edition. © Pearson Education Limited 2009. Created by Gregory Kuhlemeyer. expected future cash flows.Firms must first analyze their expected future cash flows. greater more stable the greater the debt capacity.The greater and more stable the expected future cash flows, the greater the debt capacity. Fixed charges includeFixed charges include: debt principal and interest payments, lease payments, and preferred stock dividends. Debt Capacity – The maximum amount of debt (and other fixed-charge financing) that a firm can adequately service. What is an Appropriate Amount of Financial Leverage?

70. 16.70 Van Horne and Wachowicz, Fundamentals of Financial Management, 13th edition. © Pearson Education Limited 2009. Created by Gregory Kuhlemeyer. Interest Coverage EBIT Interest expenses Interest Coverage EBIT Interest expenses Indicates a firm’s ability to cover interest charges. Income Statement Ratios Coverage Ratios A ratio value equal to 1 indicates that earnings are just sufficient to cover interest charges. Coverage Ratios

71. 16.71 Van Horne and Wachowicz, Fundamentals of Financial Management, 13th edition. © Pearson Education Limited 2009. Created by Gregory Kuhlemeyer. Debt-service Coverage EBIT Interest expenses Principal payments / (1-t) { Interest expenses + [Principal payments / (1-t) ] } Debt-service Coverage EBIT Interest expenses Principal payments / (1-t) { Interest expenses + [Principal payments / (1-t) ] } Indicates a firm’s ability to cover interest expenses and principal payments. Income Statement Ratios Coverage Ratios Allows us to examine the ability of the firm to meet all of its debt payments. Failure to make principal payments is also default. Coverage Ratios

72. 16.72 Van Horne and Wachowicz, Fundamentals of Financial Management, 13th edition. © Pearson Education Limited 2009. Created by Gregory Kuhlemeyer. coverage ratios EBIT=$500,000. Make an examination of the coverage ratios for Basket Wonders when EBIT=$500,000. Compare the equity and the debt financing alternatives. Assume that Assume that: Interest expenses$100,000Interest expenses remain at $100,000 Principal payments of $100,000Principal payments of $100,000 are made yearly for 10 years Coverage Example

73. 16.73 Van Horne and Wachowicz, Fundamentals of Financial Management, 13th edition. © Pearson Education Limited 2009. Created by Gregory Kuhlemeyer. Compare the interest coverage and debt burden ratios for equity and debt financing. Interest Debt-service Interest Debt-service FinancingCoverage Coverage Financing Coverage Coverage Equity Infinite Infinite Equity Infinite Infinite Debt 5.00 2.50 Debt 5.00 2.50 The firm actually has greater risk than the interest coverage ratio initially suggests. Coverage Example

74. 16.74 Van Horne and Wachowicz, Fundamentals of Financial Management, 13th edition. © Pearson Education Limited 2009. Created by Gregory Kuhlemeyer. -250 0 250 500 750 1,000 1,250 EBIT ($ thousands) Firm B has a much smaller probability of failing to meet its obligations than Firm A. Firm B Firm A Debt-service burden = $200,000 PROBABILITY OF OCCURRENCE Coverage Example

75. 16.75 Van Horne and Wachowicz, Fundamentals of Financial Management, 13th edition. © Pearson Education Limited 2009. Created by Gregory Kuhlemeyer. A single ratio value cannot be interpreted identically for all firms as some firms have greater debt capacity. Annual financial lease payments should be added to both the numerator and denominator of the debt-service coverage ratio as financial leases are similar to debt. A single ratio value cannot be interpreted identically for all firms as some firms have greater debt capacity. Annual financial lease payments should be added to both the numerator and denominator of the debt-service coverage ratio as financial leases are similar to debt. The debt-service coverage ratio accounts for required annual principal payments. Summary of the Coverage Ratio Discussion

76. 16.76 Van Horne and Wachowicz, Fundamentals of Financial Management, 13th edition. © Pearson Education Limited 2009. Created by Gregory Kuhlemeyer. Often, firms are compared to peer institutions in the same industry. Large deviations from norms must be justified. For example, an industry’s median debt-to-net- worth ratio might be used as a benchmark for financial leverage comparisons. Capital Structure – The mix (or proportion) of a firm’s permanent long-term financing represented by debt, preferred stock, and common stock equity. Other Methods of Analysis

77. 16.77 Van Horne and Wachowicz, Fundamentals of Financial Management, 13th edition. © Pearson Education Limited 2009. Created by Gregory Kuhlemeyer. Firms may gain insight into the financial markets’ evaluation of their firm by talking with: Investment bankers Institutional investors Investment analysts Lenders Surveying Investment Analysts and Lenders Other Methods of Analysis

78. 16.78 Van Horne and Wachowicz, Fundamentals of Financial Management, 13th edition. © Pearson Education Limited 2009. Created by Gregory Kuhlemeyer. Firms must consider the impact of any financing decision on the firm’s security rating(s). Security Ratings Other Methods of Analysis